COLUMN-Chesapeake woes may be lifeline for U.S. natgas-Campbell

May 03, 2012|Reuters

By Robert Campbell

NEW YORK, May 3 (Reuters) - Consider the following, as yethypothetical, situation. The United States' No. 2 natural gasproducer is forced into a radical shift in corporate strategy,leading to a sharp reduction in the wells it drills.

Imagine the impact this shift might have on the natural gasmarket. The cause of today's decade-low gas prices isover-enthusiastic drilling by many gas producers.

Take out one of the top drillers and perhaps a bit moreeconomic rationality prevails. At the very least the rate ofgrowth in gas production slows, giving demand time to catch upwith supply.

This isn't a mere thought experiment. It is what couldhappen very soon at Chesapeake Energy, which producesabout 9 percent of the natural gas in the United States.

Until recently, it was difficult to see Chesapeake beingforced into a major transformation.

But Reuters' revelations about its chief executive'spersonal financial dealings and yet another disappointingquarterly financial report may well force radical change uponthe company that bills itself as "America's Natural GasChampion."

Already big shareholders are starting to put their weightbehind calls for an overhaul.

It's early yet, but the potential impact on natural gasprices of a big shift in strategy cannot be ignored.

So let's look at how one might restructure Chesapeake.

The company's current strategy relies on locking up leaseson attractive shale deposits of oil and gas then --at least thisis the plan-- selling them on to other companies.

Buy low and sell high. A classic route to profit.

But there's a critical weakness in this strategy. Holdingonto the lease usually requires capital expenditure.

Often, unless a certain number of wells have been drilled ona lease within a certain number of years, the lease reverts tothe landowner within a set period of time.

If that happens there's usually no compensation to theleaseholder. Repayment of signing bonuses? Forget it!

That is the root of Chesapeake's financial problems. Itsextensive landholdings require heavy spending to maintainownership, but the company only generates a small proportion ofthe cash needed to pay for this needed investment.

For instance, in the first quarter of 2012, Chesapeake'soperations --mainly producing and selling oil and natural gas--generated only $251 million in cash.

But over the same period the company invested nearly $3.62billion in new wells, leases and equipment. The gap was made upwith funds generated by asset sales and "financing activities."

Even though the company has promised to scale back leasingefforts, its financial plan targets asset sales of at least $14billion by the end of 2013 to fund drilling and otheractivities.

CASH CRUNCH

The cash need is staggering. And the current turmoil hardlyputs Chesapeake in a good bargaining position.

Already potential bidders must be wondering if they cansqueeze out a better deal for Chesapeake's assets given itsfinancial travails.

Indeed, the company's recent efforts to clean up itstarnished reputation after Reuters reported CEO Aubrey McClendonhad borrowed up to $1.1 billion against the personal stake heacquired in wells drilled by the company may be making thingsthat much more difficult.

The controversial Founder Well Participation Program (FWPP),which entitled McClendon to take a 2.5 percent stake in eachwell drilled on a Chesapeake lease, had effectively become anoff-balance-sheet financing vehicle for Chesapeake.

Even though the debt was not guaranteed by Chesapeake, theFWPP increased the amount of borrowed money that could beemployed when drilling without swelling Chesapeake's balancesheet with yet more debt.

With the FWPP now slated to be terminated by the end ofJune, Chesapeake is faced with the prospect of having to fundthat 2.5 percent stake in every future well through its ownbalance sheet.

Here's where the gas market may benefit.

Rather than continue the high wire balancing act of tryingto raise billions of dollars each quarter to fund operations,Chesapeake abandons its pretensions to empire and focusesruthlessly on returns.

In other words, it bites the bullet, slashes drilling topreserve cash and relinquishes many leases. Vanity projects goout the window.

Jettisoning leases secured with handsome signing bonuseswould not be painless. Such a step would likely force Chesapeakeinto a huge write-off on its asset base.

Shareholders, and possibly debtholders, would have tosuffer. A host of trial lawyers in Oklahoma City would probablyfind long-term employment.

But for the rest of the gas market, the effect of such areversal of strategy at Chesapeake could well be golden.

A big aggressive driller suddenly withdraws from the market.Marginal leases that would have been produced at today's pricesfor the sake of keeping title revert to the landholder.

And probably no one touches them for a while given today'sdismal natural gas prices.

If so, the shakeout in the sector will have begun. If thesecond-biggest producer abandons the "drill to keep drilling"strategy that has run the industry into the ground, there maywell be hope for the survivors.